Fed Paper Explores Financial Literacy and Mortgage Delinquencies

The roots of the mortgage crisis have been microscopicallyrnexamined by everyone from economists to consumer groups and volumes of conten has beenrnwritten on underwriting guidelines, irrational exuberance, greed, and hubris. 

Now comes a study which offers a stunninglyrnsimple explanation, not for the whole crisis, but for a contributing factor: Americans can't add and subtract

Kristopher Gerardi, Lorenz Goette, and Stephan Meierrnrecently produced a working paper for the Federal Reserve Bank of Atlanta whichrnexamined the relationship between financial literacy and subprime mortgagerndelinquencies.  They found that the abilityrnof individuals to make simple financial calculations is strongly related to thernamount of time they spend being delinquent on their mortgages.

The study used loan level data collected by FirstAmerican LoanrnPerformance on a group of non-agency mortgages written between the late 1990srnand 2007 in three New England States, Massachusetts, Rhode Island, andrnConnecticut, and used as collateral for mortgage-backed securities purchased byrninvestors. The data set was cross referenced with data collected by the WarrenrnGroup which has been the reporter of record for real estate data in New Englandrnfor over a century. This resulted in a pool of over 70,000 mortgages.  A random sample of borrowers was pulled fromrnthis universe and divided into two groups, one of which was cold called and thernother contacted by mail. Unfortunately less than 400rnrespondents ultimately participated in the study.

Respondents were questioned to determine their financialrnliteracy as measured by their numerical ability and basic economic literacy asrnwell as their general cognitive ability. rnThey were also questioned to derive a measure of time and riskrnpreference and to gather an extensive list of socio-demographic characteristicsrnand were asked for details about the terms of their mortgages (the study alreadyrnhad extensive details on terms) and their experience shopping for that loan.

To measure numerical ability, respondents were asked fivernquestions.  One example:  “A secondhand car dealer is selling arncar for $6,000.  This is two-thirds ofrnwhat it cost new.  How much did the carrncost new?”  Cognitive ability wasrnmeasured by asking respondents to name as many animals as they could in 90rnseconds.  Two questions were asked tornmeasure basic economic literacy, for example, “Imagine that the interestrnrate on your savings account was 1% a year and inflation was 2% a year.  After one year, how much would you be able tornbuy with the money in this account?  Morernthan today?  Less than today?  Exactly the same as today?”

While cognitive ability was found to have a bearing in onernarea of the study as explained below, numerical ability was the factor that hadrnthe highest correlation to mortgage delinquency which was taken from loan datarnin three categories; the fraction of time the borrower was behind on anyrnmortgage payment; the ratio of missed mortgage payments to total paymentsrnbilled, and whether the borrower had ever been in the state of foreclosure.  

Respondents were placed in one of four groups correspondingrnto their perceived numerical ability. rnBorrowers in the group with the lowest numerical ability spent, onrnaverage, about 25 percent of the time in delinquency while those with thernhighest ability spent 12 percent.  Thernlowest group had missed 15 percent of mortgage payments on average compared tornthe highest group at 6 percent.  Therernwas an almost perfect waterfall from high literacy to low in the category of timernperiods of delinquency; the middle two quartiles of literacy were nearly equalrnand fell right in the middle of the 9 percentage point of the percent ofrnpayments missed.

In the foreclosure category, the differences acrossrnnumerical ability groups was also very large; approximately 18 percentage pointsrnbetween the group with the highest foreclosure rate and the lowest.  However, there was a deviation from thernwaterfall with the group with the second lowest numerical ability scoringrnhighest on foreclosures.  The lowestrndistress was registered again by the highest numerical ability group.  Foreclosure was the only delinquency categoryrnin which cognitive ability also was a factor with the higher cognitionrncorrelating with lower foreclosures.  

Thernstudy's authors make the point that much of the control in foreclosures is inrnthe hands of the lender and speculate that perhaps they are more reluctant to foreclosernon more intelligent borrowers.

The authors state that the results of their study suggestrnthat the correlation between financial literacy and mortgage delinquency is notrndue to financially illiterate borrowers taking on too much debt, or choosingrnexcessively risky mortgages but that the limited numerical ability might leadrnto other mistakes over the course of time, like too much spending, too littlernsavings, or inappropriate reaction to income and/or consumption shocks. 

The results also suggest that subprime borrowers withrnlimited numerical ability were no more likely than others to enter into unfavorablerncontracts.  However, the authors say thatrnthe timing of the originations of respondents' mortgages relative to thernemergence of the subprime crisis prohibit any solid conclusions in that area.

The study, according to its authors, has several implicationsrnfor future research and applications.  “First,rna normally unobservable characteristic or ability can explain part of thernheterogeneity in default behavior.” rnThis could provide insights to lenders on designing contract terms and defaultrnreduction strategies; i.e. financial institutions may have an interest inrnapplying tests of numerical ability to loan applicants.

Second, there is a question as to whether literacy could bernespecially important in the environment of rapidly falling home prices.  Because the experts differed on the characteristicsrnof the housing boom, many individuals may have relied even more heavily on thernability of rising equity to keep them in their homes.  As the market reversed, “individualsrnwith high financial literacy may have found it easier to adjust their consumptionrnand savings decisions in order to continue making their mortgagernpayments.”  

The authors conclude that their results suggest that morernintensive financial education could substantially improve financial decisions laterrnin life.  However, the next logical steprnis to randomize financial education and then track the financial decisions ofrnthese individuals over time.

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